Are Qilu Expressway’s (HKG:1576) Statutory Earnings A Good Guide To Its Underlying Profitability?

Broadly speaking, profitable businesses are less risky than unprofitable ones. That said, the current statutory profit is not always a good guide to a company’s underlying profitability. Today we’ll focus on whether this year’s statutory profits are a good guide to understanding Qilu Expressway (HKG:1576).

We like the fact that Qilu Expressway made a profit of CN¥434.6m on its revenue of CN¥957.1m, in the last year. In the chart below, you can see that its profit and revenue have both grown over the last three years.

See our latest analysis for Qilu Expressway

SEHK:1576 Income Statement, February 4th 2020
SEHK:1576 Income Statement, February 4th 2020

Importantly, statutory profits are not always the best tool for understanding a company’s true earnings power, so it’s well worth examining profits in a little more detail. So today we’ll look at what Qilu Expressway’s cashflow tells us about its earnings, as well as examining how issuing shares is impacting shareholder value. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Qilu Expressway.

A Closer Look At Qilu Expressway’s Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. The ratio shows us how much a company’s profit exceeds its FCF.

Therefore, it’s actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. While having an accrual ratio above zero is of little concern, we do think it’s worth noting when a company has a relatively high accrual ratio. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to June 2019, Qilu Expressway had an accrual ratio of -0.17. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CN¥857m during the period, dwarfing its reported profit of CN¥434.6m. Qilu Expressway shareholders are no doubt pleased that free cash flow improved over the last twelve months. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Qilu Expressway issued 32% more new shares over the last year. Therefore, each share now receives a smaller portion of profit. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company’s profits, while the net income level gives us a better view of the company’s absolute size. Check out Qilu Expressway’s historical EPS growth by clicking on this link.

A Look At The Impact Of Qilu Expressway’s Dilution on Its Earnings Per Share (EPS).

Qilu Expressway has improved its profit over the last three years, with an annualized gain of 27% in that time. But on the other hand, earnings per share actually fell by 3.6% per year. While we did see a very small decrease, net profit was basically flat over the last year. In contrast, earnings per share are actually down a full 25%, over the last twelve months. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

If Qilu Expressway’s EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company’s share price might grow.

Our Take On Qilu Expressway’s Profit Performance

In conclusion, Qilu Expressway has a strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share are dropping faster than its profit. Based on these factors, it’s hard to tell if Qilu Expressway’s profits are a reasonable reflection of its underlying profitability. While earnings are important, another area to consider is the balance sheet. If you want to,you can see our take on Qilu Expressway’s balance sheet by clicking here.

Our examination of Qilu Expressway has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to ‘follow the money’ and search out stocks that insiders are buying. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying to be useful.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.